10 Indicators of a Great Stock

The goal is to identify the Holy Grail of stock investing … the stock … the kind of stock that, if stocks were people, then Apple, General Electric, Proctor & Gamble, and Microsoft would be peasants compared to this king. Yeah, that’s the kind of stock that would be the Grand Pooh-Bah of your portfolio! Well, hold your horses.

Seriously, it’s unlikely that you’ll find a stock with all ten hallmarks, but a stock with even half of them is a super-solid choice. Get a stock with as many hallmarks as possible and you likely have a winner.

The company has rising profits

The very essence of a successful company is its ability to make a profit. In fact, profit is the single most important financial element of a company. Without profit, a company goes out of business. If a business closes its doors, private jobs vanish. In turn, taxes don’t get paid. This means that the government can’t function and pay its workers and those who are dependent on public assistance.

Profit is what is left after expenses are deducted from sales. When a company manages its expenses well, profits will grow.

The company has rising sales

Looking at the total sales of a company is referred to as analyzing the top-line numbers.

A company (or analysts) can play games with many numbers on an income statement; there are a dozen different ways to look at earnings. Earnings are the heart and soul of a company, but the top line gives you an unmistakable and clear number to look it. The total sales (or gross sales or gross revenue) number for a company is harder to fudge.

It’s easy for an investor — especially a novice investor — to look at sales for a company for a particular year and see whether it’s doing better or worse than in the prior year. Reviewing three years of sales gives you a good overall gauge of the company’s success.

The company has low liabilities

All things being equal, most investors would rather have a company with relatively low debt than one with high debt. Too much debt will kill an otherwise good company.

Because a company with low debt has borrowing power, it can take advantage of opportunities such as taking over a rival or acquiring a company that offers an added technology to help propel current or future profit growth.

Notice that you aren’t talking about a company with no debt. A company with no debt or little in the way of liabilities is a solid company. But in an environment where you can borrow at historically low rates, it pays to take on some debt and use it efficiently.

Secondly, notice that liabilities are an issue. It isn’t always conventional debt that may sink a company. What if that company is simply spending more money than it’s bringing in? Liabilities or “total liabilities” takes into account everything that a company is obligated to pay, whether it’s a long-term bond (long-term debt), paying workers, or the water bill. Current expenses should be more than covered by current income, but you don’t want to accumulate long-term debt, which means a drain on future income.

Also, in some industries, the liabilities can take a form that isn’t typically conventional debt or monthly expenses.

To discover some good parameters of acceptable debt, look at the company’s financial ratios on debt to assets.

The stock is at a bargain price

You can look at the value of a company in several ways, but the first thing you should look at is the price-to-earnings ratio (P/E ratio). It attempts to connect the price of the company’s stock to the company’s net profits quoted on a per share basis. For example, if a company has a price of $15 per share and the earnings are $1 per share, then the P/E ratio is 15.

Generally speaking, a P/E ratio of 15 or less is a good value, especially if the other numbers work out positively. When the economy is in the dumps and stock prices are down, P/E ratios of 10 or lower are even better. Conversely, if the economy is booming, then higher P/E ratios are acceptable.

Investing in a company that is losing money is making a bet, and more importantly, it isn’t a bargain at all.

A stock may also be a bargain if its market value is at or below its book value (the actual accounting value of net assets for the company).

Dividends are growing

Dividends are the long-term investor’s best friend. Wouldn’t it be great if after a few years of owning that stock, you received total dividends that actually dwarfed what your original investment was? That’s more common than you know!

Dividend growth also carries with it the potential growth of the stock itself. A consistently rising dividend is a positive sign for the stock price. The investing public sees that a growing dividend is a powerful and tangible sign of the company’s current and future financial health.

A company may be able to fudge earnings and other soft or malleable figures, but when a dividend is paid, that’s hard proof that the company is succeeding with its net profit. Given that, just review the long-term stock chart (say five years or longer) of a consistent dividend-paying company, and 99 times out of 100, that stock price is zigzagging upward in a similar pattern.

The market is growing

Take a look at demographics and market data and use this information to further filter your investing choices. You could run a great company, but if your fortunes are made when a million folks buy from you, and next year that number shrinks to 800,000, and the year after that it shrinks again, what will happen to your fortunes?

The company is in a field with a high barrier to entry

A high barrier to entry simply means that companies that compete with you will have a tough time overcoming your advantage. This gives you the power to grow and leave your competition in the dust.

The company has a low political profile

History shows that companies that are politically targeted either directly or by association (by being in an unpopular industry) can suffer. There was a time that holding tobacco companies in your portfolio was the equivalent of garlic to a vampire.

All things being equal, you may want to hold a stock in a popular industry or a nondescript industry rather than one that attracts undue (negative) attention.

The stock is optionable

An optionable stock (which has call and put options available on it) means that you have added ways to profit from it (or the ability to minimize potential losses). Options give a stockholder ways to enhance gains or yield added revenue.

Say you do in fact find the perfect stock, and you truly load up and buy as many shares as you can lay your hands on, but you don’t have any more money to buy another batch of shares.

Fortunately, you notice that the stock is optionable and see that you can speculate by buying a call option that allows you to be bullish on 100 shares with a fraction of the cash needed to actually buy 100 shares. As the stock soars, you’re able to take profits by cashing out the call option without having to touch the stock position at all.

Now, with your stock at nosebleed levels, you’re getting a little nervous that this stock is possibly at an unsustainable level, so you decide to buy some put options to protect your unrealized gains from your stock. When your stock does experience a correction, you cash out your put with an enviable gain. With the stock down, you decide to take the proceeds from your put option–realized gains and buy more of the stock at favorable prices.

Options (both the call and the put in this scenario) give you the ability to bank more gains from the same great stock. Find out more about options in the book High-Level Investing For Dummies (published by Wiley).

The stock is benefiting from favorable megatrends

A megatrend is a trend that affects an unusually large segment of the marketplace and may have added benefits and/or pitfalls for buyers and sellers of a given set of products and services. A good example of a megatrend is “the aging of America”; the United States has more than 85 million people who are getting ready for retirement as they reach and surpass the age of 65 (although some assume a larger number when they include folks who are over 50). Those companies that provide services and products for senior citizens would have greater opportunities to sell more of what they provide and would then be a good consideration for investors.